SEC Division of Investment Management staff letter: United Municipal Bond Fund

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON. D.C. 20549

DIVISION OF

INVESTMENT MANAGEMENT
January 27, 1995

ACT r CA-- t/
SECTION
Catherine s. Bardsley, Esq. RULE /7 tL - 7 Kirkpatrick & Lockhart PUBLIC 1800 M street, N. W. AVAILABILITY II).Î/7~ Washington, D. C. 20036-5891 , , Re: Uni ted Municipal Bond Fund (pub. avail. Julv 30. 1992)

Dear Ms. Bardsley:
By letter dated October 29, 1991, United Municipal Bond

Fund, Inc. and united High Income Fud, Inc. (the "Funds")

requested the staff' s assurance that it would not recommend

enforcement action to the Commission under section 17 (a) of the

Investment Company Act of 1940 ("1940 Act") if the Funds, in

reliance on Rule 17a-7 under the 1940 Act, bought and sold

between themselves municipal bonds for which market quotations

are not readily available. The Funds proposed to value the bonds

by using the price provided by the Funds' independent pricing

service for purposes of calculating net asset value under R~le

2a-4 under the 1940 Act. The staff granted the Funds no-action

relief in United Municipal Bond Fund (pub. avail. July 30, 1992),

but not on the terms requested. Instead, the staff required that

the Funds value the municipal bonds by averaging prices obtained

from at least three independent matrix pricing services, or by

averaging three independent bid prices, or by averaging three

prices obtained from some combination of pricing serv~ces and bid prices. By letter dated October 18, 1994, you requested that the staff reconsider its position, and permit the Funds to buy and sell certain municipal bonds between themselves using the price provided by their independent pricing service, as proposed in the Funds' ini tial no-action request. You state that taking the average of prices provided by pricing services, bid prices, or

some combination thereof results in an artificial gain or loss

for the purchasing or selling Fund because the average price is

unlikely to be the same as the price that the Fund uses to

compute net asset value. Moreover, completing the transaction using the average of two or three bid prices always \ will be disadvantageous to the seller of the security. .

You believe that the use of the Funds' pricing service to

price transactions between the Funds provides a reliable method

of determining the value of the securities, particularly in view

of the steps the Funds take to verify the accuracy of the prices

quoted. The Funds' use the prices provided by an independent

pricing service, Muller Data corporation ("Muller"), to value

their municipal bonds for purposes of Rule 2a-4. Muller's staff

determines the price of a particular security by "hand pricing,"

which consists of gathering market information about that

security (~, trade execution data and the latest bid and ask

quotes for the security, as well as information about offerings

of similar securities). lj The Funds' adviser, Waddell & Reed

(the "Adviser"), regularly tests the overall accuracy of Muller's

pricing system. Each week, the Adviser obtains prices from

another pricing service for those securities that represent 1% or

more of the net assets of each of its funds that use Muller's

_ _ pricing service. The Adviser compares the total of the alternate

prices to the total of Muller's prices. Y Further, each Fund" s

board annually reviews and approves the use of Muller and the

Adviser's testing methodology. In addition, the Funds'

independent auditor, Price Waterhouse, as part of its annual

review of the Funds' internal control structure, tests the

reliability of Muller's pricing system. Specifically, Price

Waterhouse compares the aggregate of Muller's prices with the

aggregate of the alternate prices from its own pricing module.

The Funds are not requesting relief with respect to

transactions invol ving municipal bonds with an embedded swap, cap

or floor, or other derivative structure that would impair the

liquidity of the bond because of the customized nature of the

structure, the information (or lack thereof) available about the bond, . or other factor(s). The Adviser will determine whether a lj On November 9, 1994, the Commission approved a program by

the Municipal Securities Rulemaking Board to make pricing

information available to investors. Securi ties Exchange Act

Release No. 34955 (November 9, 1994), 59 FR 59810 (order

approving file No. SR-MSRB-94-09). Under the first phase of

the program, reports of inter-dealer transactions and daily

high-low and average price figures for the most frequently

traded issues will be made public. Under phase two and

phase three of the program, these requirements will be

expanded to include institutional customer transactions and

retail transactions. Finally, the program will implement

more contemporaneous reporting of transaction information.

We expect that such information will be utilized by pricing

services and persons charged with evaluating the performance

of pricing services as it becomes available.

Y You state that the Adviser believes that its testing methodology is accurate and ,that, it would promptly consider

al ternati ves if, in the future , its methodology did not

accurately test Muller's prices.

• 2

bond should be excluded on the basis of this description, subject

to the general review and oversight by each Fund's board of

directors. You also state that the Funds will not rely on the

staff's no-action position to engage in transactions in municipal

bonds that the Adviser knows or has reason to know are in

default, including those that are in technical default. 1/

The staff agrees to modify the pricing condition in the

original no-action relief granted to the Funds, and, accordingly,

would not recommend that the Commission take any enforcement

action under Section 17 (a) if the Funds buy and sell portfolio

securities between themselves using a price provided by the

pricing service that values the Funds' municipal bonds for Rule

2a-4 purposes, provided that the Funds comply with the conditions

in your October 18, 1994 letter and above. !/

Sincerely,
1Q/Wc J1l. (lQ~L
/Jana M. Cayne

Attorney'
Office of Chief Counsel

1/ Confirmed in a telephone conversation between Catherine

Bardsley and Amy Doberman, November 3, 1994.

!/ The other conditions to no-action relief that wére included

in the original no-action letter remain unchanged.

• 3

scum LOBBY. 9T FLR
180 M ST N:W, BON, MA

WASHINGrN, D,C. 20036-5891 HASBURG, PA

MI, FL

1EONE (2) 778 NE YOR NY m. 2+19
PITURGH, PA

W:IM (22) 77s.1oo CA TI S, BARLE

(202) 778-9289
October 18 , 1994
VIA XESSENGER

Special Counsel

Di vi~~on of Investment Management

Securities and Exchange Commission

450 5th Street, N.W.

Washington, D.C. 20549

Re: Your Ref. No. 91-536-CC

united Municipal Bond Fund, Inc.

United Municipal High Income Fund. Inc.

Dear Ms. Doberman:

This letter is to respond to the issues raised in the

telephone conference call August 12, 1994, regarding the request

of United Municipal Bond Fund, Inc., and United Municipal High

Income Fund, Inc. ("Funds") for no-action assurance as to the

application. of Rule 17a-7 under the Investment Company Act of 1940 ("1940 Act") and the staff's above-referenced response. In that call, the staff requested that the Funds: (a) make certain

changes in their proposed definition of an embedded derivative

for puroses of determining which municipal bonds are to be

excluded from the relief requested; (b) address further the

testing of the prices from the pricing service used by the Funds;

and (c) provide a consolidated statement of the facts and discus￾sions contained in the prior letters submitted on behàlf of the

Funds since the issuance of the staff's initial response.

As presented more fully below, the Funds agree to the

staff's requested revisions to the definition of embedded deriva￾ti ves and have provided further information as to the testing of

the pricing service's prices. This letter also consolidates the

substance of my prior letters of April 20, 1993 and January 4,

1994 to Thomas S. Harman and of June 22, 1994 to Jana M. Cayne

(copies of which letters are attached for your reference). As in each of those prior letters, the Funds respectfully request that

the staff re-evaluate its no-action response and modify that

response to permit the Funds to use the price provi~ed by an

independent pricing service as the current market ptice for

puroses of compliance with Rule 17a-7.

DC-88. ,

BACKGROUN
By letter dated October 29, 1991, the Funds requested that

the staff provide assurance that it would not recommend enforce￾ment action if the Funds between themselves buy and sell muni￾cipal bonds at the prices provided by the independent pricing

service which is also used by each Fund to value the municipal

bonds in its portfolio for purposes of Rule 2a-4 under the 1940

Act. The staff's response, which was sent to the Funds and made

publicly available on JUly 30, 1992, stated that the staff would

not recommend enforcement action under Rule 17a-7 if, as the

first of five conditions set forth in the response:

(1) the municipal bonds are valued by averaging prices

obtained from at least three independent matrix pricing

services, or by averaging three independent bid prices, or

by averaging three prices obtained from some combination of

independent pricing services and independent bid prices;

( footnote omitted) ...
(copies of the respective request and no-action letters are

enclosed for your reference.) Shortly thereafter, at the Funds'

request, I spoke with Ms. Cayne about whether in certain circum￾stances, the numer of prices required to be averaged could be

reduced from three to two.

This possibility was not pursued further by the Funds

because, after the first transaction in accordance with the no-

action letter, it became apparent that there was a more funda￾mental problem with the averaging approach itself. specifically,

in a sale made in reliance on the no-action letter and at a price

determined by averaging two independent bid prices and one price

from an independent pricing service, the selling Fund experienced

a loss, because each of the bid prices, and therefore the average

of the three prices, was lower than that provided by the pricing

service (whose price, had there been no sale, would have been

used for the Fund's valuation pursuant to Rule 2a-4) .1/ Waddell

& Reed Investment Management Company, the investment adviser to

each Fund, thereafter informed the Directors of the Funds that it

would investigate further the impact of the averaging approach

1/ The Fud did not suffer any actual loss because ah amount

representing the difference between the sale price and the price

provided QY the pricing service was promptly paid to the Fund by

the Fund's investment adviser.

and that until the issue was resolved to the satisfaction of the

Funds, no further transactions would be made in reliance upon the

no-action letter.

SPECIFIC ISSUES

Artificial Gain or Loss

As previously expressed in telephone conversations with the

staff and in my letter of April 20, 1993, the Funds believe that

implementation of the first condition set forth in that response

disadvantages one, and possibly both, of the parties to the

transaction in that the execution price prescribed by that condi￾tion results in an artificial element of gain or loss on the

transaction. This gain (or loss) is artificial for two reasons.

One is that the prescribed execution price rarely, if ever, will

be the price at which the particular securities would otherwise

be traded with an unaffiliated counter-party. In addition, the

gain or loss is artificial because the execution price is

differently from the method used by the Funds in

calculating net asset value per share. As a result, the

purchaser (as opposed to the seller) will have an immediate and

unintended, unrealized gain or loss. The use of a price based on

the average of three prices, as required under the first condi￾tion of the no-action letter, creates an element of gain or loss

that is economically artificial but nonetheless has real, adverse

tax and accounting effects to the Funds and their respective

calculated' shareholders.
Fund typi-
For purposes of Rule 2a-4 under the 1940 Act each

cally values the municipal bonds held in its portfolio on the

basis of priees provided by an independent pricing service. The

problem with the first condition of the no-action letter is

simply that, in virtually all cases, the price derived from the average of three numers will be different from anyone of the three. certainly this differential does not represent a better

or more accurate market-based valuation but does result in more

or less gain or loss on a sale transaction. The problem is

illustrated by the following example:

Fund A has a municipal bond in its portfolio that it

purchased at par (100.00) and is currently priced at 105.00

by Fund A's independent pricing service. In order to sell

the bond to Fund B under the no-action letter, FÙnd A

obtains two independent bids, 105.00 and 104.00, which when

averaged with the price from the pricing service, produce a

price of 104.66.

Using a sale price of 104.66 results in a gain af 4. 66; had

the pricing service price been used as the sale pricé, the gain

to Fund A would have been 5.00. Fund A's net asset value is also

0.34 less using the average than it would have been using the

price provided by the pricing service (which would have been used

to value the bond had it not been.sol(i). There is a correspond￾ing impact on Fund B. If 104.66 is the initial value of the bond

in Fund B's portfolio, FundB will have a built-in potential gain

or loss of 0.34 simply by virtue of the differential between the

averaged price and the pricing service valuation. Thus, when

Fund B next determines its net asset value and values the bond at

the price provided by the independent pricing service (assume

105.00 or higher), Fund B's net asset value will reflect an

increase of 0.34 which is artificial in that it derives solely

from the change in pricing methodology. Thus, the pricing

methodology prescribed in the first condition of the no-action

letter creates an artificial element of gain or loss to each

party that distorts the economic reality of the transaction.

In condition one of the no-action letter, the staff may have

sought to parallel the approach in section (b) (4) of the Rule 17a-7, i.~., using the average of the highest current independent

bid and lowest current independent offer. Rule 17a-7 (b) (4) may

reflect the appropriate valuation for securities whose values

under Rule 2a-4 are derived according to that methodology. It is

not, however, an appropriate methodology for securities which

regularly use a different valuation method such as an independent pricing service. (4) , as To apply the general methodology of Rule 17a-7 (b)

reflected in condition one, so as to require a Fund to' use a

different methodology for inter-fund transactions than the Fund

does for Rule 2a-4 net asset value determinations serves no

policy purpose and instead has unwarranted and adverse conse￾quences to the Fund and its shareholders. Indeed, it seems con￾trary to the policy underlying Rule 17a-7 that two funds with the

same pricing policy that enter into a cross-transaction could not

use that pricing policy and instead must use a different pricing

method that will almost always result in an immediate unrealized

gain or loss to the purchaser together with a distortion of the

seller's gain or loss. Aècordingly, the Funds request that the

staff permit the Funds to use the price provided by an indepen￾dent pricing service which the Fund otherwise uses for Rule 2a-4

purposes as the current market price for puroses of \compliance

with Rule 17a-7.

October i8, 1994

/ Pricina service

Each Fuhd has, since its inception, used the prices provided

by Muller Data Corporation ("Muller") to value the municipal obligations in the Fund's portfolio for purposes of Rule 2a-4

under the 1940 Act. In our discussions with Muller personnel,

Muller has described its services to the Funds as "hand pricing"

rather than "matri~: pricing." Muller does not attempt to follow

a general universe of municipal securities for its mutual fund

clients, but rather, it has advised us, it follows only the

securities in those clients' portfolios. Muller has a staff of

evaluators to whom clients' secuities are assigned, typically

according to particular segments of the municipal market, such as

pre-~efunded bonds or general obligations. We understand that

evaluators operate generally as follows: in the morning, an

evaluator calls his or her contacts in the market (~.g., dealers

and portfolio managers) to gather further information about

recent trades, current bids, offerings of similar securities,

general conditions or movements in the market or in particular

market sectors, etc.; and in the afternoon, the evaluator makes

an evaluation of each security for which he or she is responsible. We have discussed with Muller personnel certain of the

publicized concerns relating to municipal bonds with embedded

derivatives and the attendant pricing issues. In this context,

we note that Muller regards these issues as raised primarily by

bonds with embedded swaps, caps or floors. This is in contrast

to municipal bonds with common variable or floating rate

features, which Muller characterizes as relatively easy to

follow.
We understand, however, that dealers have responded to

concerns regarding embedded derivatives by increasing the amount

and frequency of information provided to services such as Muller

and others in the secondary market. Muller is one of the partic￾ipants in the Task Force on Derivatives Information Standardiza￾tion formed last fall by the Public Securities Association to

study the standardization and dissemination of information on

municipal bond derivatives.

KIRKATRICK & LOCT

Testino of Pricino Service Prices " Waddell & Reed Investment Management Company ("Manager"), in

its capacity as the investment adviser to each Fund, regularly

tests the overall accuracy of Muller's pricing system. Under its

current procedures, 'each week the Manager obtains from another

pricing service prices for those securities which represent 1% or

mòre of the ,net assets of all funds advised by the Manager that

use Muller's pricing service. The total of these alternate

prices is then compared to the total derived from Muller's prices

tor the same securities. Under current procedures, on an annual

basis each Fund's Board of Directors reviews and considers the

continuance of the use of the pricing service and the Manager's

testing methodology.

In addition, in connection with its annual review of the

internal control structure for the Fuds and the other funds for

which it serves as independent accountants, Price Waterhouse

tests the reliability of Muller's pricing. Price Waterhouse uses

its Automated systems and Services for Investment Securities

Transactions ("PW-ASSIST") pricing module to evaluate the prices

provided by Muller. Price Waterhouse compares the aggregate of

the prices provided by Muller and the aggregate of the alternate

PW-ASSIST prices. Where the difference is immaterial in relation

to a fund's net assets, Price Waterhouse is able to establish an

independent basis for reliance that the prices provided by Muller

are indicative of market value.

As reported in my letter of June 22, 1994, a then-recent,

representative application of the 1% test performed by.the

Manager was as follows:

For united Municipal Bond Fud, Inc., 30 of a total of

approximately 100 securities were tested, representing

approximately $400 million of a total $1 billion in assets.

For united Municipal High Income Fund, Inc., 30 of a

total of approximately 150 securities were tested,

representing approximately $90 million of a total $350 million in assets. In addition, please be advised that a recent representative

application of the 1% test was follows: '

, For United Municipal Bond Fund, Inc., 31 of a total of

approximately 205 securities were tested, representing

approximately $377 million of a total $944 billion in

assets.
For united Municipal High Income Fund, Inc.', 28 of a

total of approximately 191 securities were tested, repre￾senting approximatei~ $89 million of a total $328 million in

assets.

Fuher, the turnover rates, as stated in the annual reports for the respectivé Funds' fiscal years ended September 30, 1989,

though 1993, were as follows:
For united Municipal Bond Fund, Inc., the turnover

rates were 226%, 181%, 144%, 125% and 94.5%, respectively.

For united Municipal High Income Fund, Inc., the

turnover rates were 38%, 27%, 60%, 54% and 26%, respectively. For the fiscal year ended September 30, 1994, the

portfolio turnover rates were 62. 6% (unaudited) for united

Municipal Bond Fund, Inc., and 26.3% (unaudited) for united

Municipal High Income Fund, Inc.
The Manager believes that its testing methodology provides a

meaningful test of the overall accuracy of the prices provided by

the pricing service used by the Funds. If the Manager were to

determine this methodology did not meaningfully test that

service's prices, it would promptly consider the alternatives

available and take such actions as it deemed necessary or appro￾priate, including notice to the Fund's Board of Directors of the

actions taken and/or recommended.

Exclusion of MuniciÐal Bonds with Emedded Derivatives

In view of the concerns previously expressed by the staff

regarding municipal bonds with embedded derivatives, the Funds

had proposed limiting their original no-action request so as to

exclude inter-Fund sales of municipal ,bonds with embedded deriva￾relief requested. Based on our

discussions with the staff with respect to defining ~mbedded

derivatives for this purpose, the Funds agree that the municipal

bonds to be excluded from the no-action relief requested by the

ti ves from the scope of the

those with an "embedded swap, cap or floor, or other

derivative structure that would impair the liquidity of the bond

Funds are .

KIRKATRICK & LOCKHT

because of the customized nature of the structure, the informa- ,/ tion (or lack thereof) available about the bond, or other factor (s) . n Each Fund anticipates that determinations as to a bond's

exclusion or eligibility would be made by its investment adviser,

subject to the general review and oversight by the Board of

Directors. It is the Funds' understanding that certain types of

municipal bonds with' aspects which might technically be deemed

"derivative", such as those having a variable amount, adjustable

rate or put feature, nevertheless do not necessarily present

valuation concerns. Further, a determination that a bond had an

embedded structure which "would impair liquidity" would not

necessarily constitute a determination that the bond is illiquid

for purposes of a Fund's limitation on illiquid securities.

---

We hope the foregoing is responsive to your requests and

will enable the staff to permit the Funds, for purposes of Rule

17a-7, to treat the price provided by an independent pricing

service, and which is the price otherwise used for Rule 2a-4

purposes, as the current market price of a municipal bond, other

than a municipal bond with an embedded derivative.

If you have further questions or believe that there are

further issues which remain to be resolved, please contact either

the undersigned or Clifford J. Alexander at 202/778-9068.

Thank you for your consideration of this important matter

for the Funds.

Very truly yours,

~ S. ~J~
Catherine s. Bardsley ~
Enclosures cc: Sharon K. Pappas, Esq.

Clifford J. Alexander, Esq.